Educational Articles

Using the Value Line Page: Is Microsoft a Good Investment? - November 26, 2010

Reuben Gregg Brewer
| November 26, 2010

Most people know the name Microsoft (MSFT – Free Value Line Research Report), and its widely used Windows operating system and Office software suit. This is a testament to the company storied past, but also a sign of the obstacles it faces.

As the Business Description on the Value Line research report highlights, the company operates in many different segments of the technology industry, including operating systems, software, game consoles, servers, and entertainment devices. While the company’s X-Box is well known, it is hardly the dominant player in the game console sector, unlike the position held by the Office and Windows franchises. Likewise, Microsoft does have very competitive offerings in the server space, but, again, it isn’t the only player and isn’t the market leader. Some of the other products the company offers, meanwhile, like the Zune player and the Windows Phone operating system, are often little more than bit players in their respective spaces.

Clearly, the company is losing the innovation race to rivals such as Google (GOOG) and Apple (AAPL). This is a bad thing for a company that was once feared for both its size and technological prowess. In fact, recent changes in the company’s financial structure highlight the changing role it is playing in the technology industry. For example, after long resisting a payout, the company began paying a dividend in 2003, which can be seen in the historical data in the Statistical Array. Although once unthinkable, the move seemed to cement in many people’s minds the company’s status as “mature.”

As if a dividend weren’t bad enough, Microsoft began using debt as a funding source in 2009, when it issued nearly $4 billion dollars of bonds. Since that time, the company’s debt load has more than doubled, as can be seen in the Statistical Array. Note that the current level of debt, over $10 billion, is shown in the Capital Structure box to the left of the Value Line research report. In the technology arena, being “mature” enough to pay a dividend and use debt is not usually viewed as a good thing. The preference is for fast-growing companies the issue equity to fund their growth.

Thus, there is a very valid concern that Microsoft is an old tech titan that has seen its best days and is now living off of its former glory. This leads to two questions: “Is that such a bad thing for investors?” and “Can the company eventually reinvent itself the way International Business Machines (IBM – Free Value Line Research Report) has over and over again?”

“Is that such a bad thing for investors?”

Microsoft has definitely changed over the years and it is clearly benefiting from the entrenched positions of its major brands. It remains a savvy company, however, and some of its financial moves may reflect the wisdom of old age without a concurrent level of aches and pains. For example, the dividend was initiated at a time when the company was suffering a chorus of negative publicity over its massive cash hoard. The dividend effectively silenced the critics. However, because of the company’s ability to generate huge amounts of free cash flow, the accumulation of cash on its balance sheet hasn’t been materially hampered by the dividend payments it has made. In fact, from 2009 to the end of September 2010, the company’s cash balance increased by over $10 billion dollars (this information can be found in the Current Position box to the left of the Value Line research report). It would appear that both the company and shareholders are benefiting from the dividend decision.

With regard to debt, debentures still make up only about 20% of the company’s capital structure (this information can be found in the Capital Structure box). So the company is far from heavily leveraged. Moreover, the cash balance dwarfs its debt load, meaning that the company’s “net debt” (debt minus cash) is zero. What the debt does allow, however, is for Microsoft to leverage its returns for shareholders in a very cost-effective manner. Indeed, with interest rates at historically low levels, the debt costs the company very little in the form of interest payments.

Additionally, as the return on total capital and return on shareholder equity lines in the Statistical Array show, the debt is being put to good use. When a company has no debt, these two figures are the same. When debt is employed, the two numbers should be different, with debt amplifying the return on shareholder equity figure. If debt goes up but returns on shareholder equity do not, then debt isn’t being used effectively. However, as is the case with Microsoft, if debt goes up and the disparity between the two ratios expands, then the debt is benefiting shareholders. Again, it appears that a little maturity is leading to more savvy financing decisions at Microsoft.

So while the company is clearly mature relative to many of today’s tech darlings, this same maturity is being used to better serve investors. The dividend isn’t hampering the company’s cash generating ability and it is a growing source of income for shareholders. The debt, meanwhile, seems like an opportunistic financing decision that is benefiting shareholders while not hampering the company with significant interest payments. There is something to be said for the wisdom of age.

“Can Microsoft Reinvent Itself?”

This is a harder question to answer. Although the company is clearly benefiting from its dominant brands (the current trends in the Windows and Office business lines are positively highlighted in the Analyst Commentary at the heart of the Value Line research report), it has hardly rested on its laurels. Microsoft has continually, though perhaps not always successfully, moved into new spaces. A good example is the company’s Windows Phone operating system. Although Google’s open source Android phone operating system and Apple’s and Blackberry’s (The Blackberry is a product of Research in Motion (RIMM)) proprietary operating systems are more dominant, Microsoft is at least making an attempt to move into this fast-growing space.

It could be that Microsoft’s future isn’t in being the dominant player in any one space. It is possible that the company will simply have to get used to sharing the spotlight, as it does with its highly successful X-Box game systems. While the Zune player has been among the company’s notable product failures (there are plenty of others), the company’s strong financial position allows it to make mistakes without negative consequences for shareholders. In fact, the company earns Value Line’s top score for Financial Strength (A++) and high marks for Stock Price Stability and Earnings Predictability (all of these proprietary measures can be found in the Ratings box at the bottom right of each Value Line research report). Note that the company’s range bound stock price has resulted in a relatively poor score for Price Growth Persistence.

The company is also exploring different ways to make use of its technology. The most notable is its recent search partnership with Yahoo! (YHOO). Although Microsoft was one of the top search players, its share of the search business was small compared to search king Google. By allowing Yahoo! to use its new Bing search technology, Microsoft effectively doubled its share of the search market overnight. Perhaps Microsoft would have preferred to do that organically, but being a service provider to a major rival is a unique twist that shows a willingness to try new and varied business approaches. One could easily mistake such actions as IBM-like.

In addition, the company is moving aggressively and successfully into new technology such as so-called “cloud computing.” Interestingly, the company’s dominance in the operating system and office productivity space lends a great deal of support to its efforts in this emerging technology arena. If customers already trust Microsoft products and understand how to use them, it makes sense to stay with what they know when trying out a new service in a similar product line. Moreover, the company has, over the years, leveraged its strong brands to expand its product lineup successfully, adding such products as SharePoint to its roster of offerings. As new technology comes on the scene, it is likely that Microsoft will at least attempt to participate. The successful forays add to the company’s future prospects and help to transform Microsoft slowly and transition it away from its reliance on just a few offerings.

The interesting thing about Microsoft is that the company is so large and dominant that the changes it is making are often overlooked. So, while the company is reliant on a few core brands, it has over the years diversified and changed. While the changes haven’t been as obvious as those made at IBM, the changes are happening just the same.

When considered as a whole, Microsoft appears to have a profitable future ahead of it. Indeed, Value Line analyst Charles Clark expects earnings over the next few years to advance at a 12.5% annual clip, on average, above the level the company achieved over the past 10 years. This figure can be found in the Annual Rates box on the left of the page. That rate of earnings growth leads to earnings in the $3.35 range over the next three to five years (this projection can be found to the far right of the Statistical Array) and a projected price range of $45 to $55 (found in the Projections Box to the left of the Graph or displayed visually with dotted lines on the right side of the Graph). Add in the expected dividend payments and that amounts to a projected annualized total return between 16% and 21% per year. Conservative investors looking for a way to invest in the technology space should strongly consider Microsoft.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.